UNCERTAINTY, FOREIGN DIRECT INVESTMENT AND ECONOMIC GROWTH: EVIDENCE FROM DEVELOPING ASIA

Abstract

Voluminous work has been produced on transnational investments-led growth through technology transfers and imitation yet the empirics remain inconclusive. We consider regional differentials in absorption capacity and capacity to imitate as major factors underlying mixed results across the empirical literature about Foreign Direct Investment (FDI) and economic growth nexus. This work, broadly argues that the impact of FDI on growth depends on its interaction with human capital and domestic investment. This study also proposes that transnational investments are prone to uncertainty and that the estimated relationship is sensitive to proxies and measures used for uncertainty. In this backdrop, this study envisages examining the role of FDI in economic growth of Developing Asia over a time span of 1980-2007. To put the arguments to an empirically testable framework, building on endogenous growth theory, a model for growth is derived based on Romer (1991) and developed by Borensztein et al. (1998) which we extend from a single equation to a Simultaneous Equation Model (SEM) to deal with potential simultaneity across the variables. Generalized Method of Moments (GMM) is employed to control for endogeniety of the dependent variables. This study finds a strong positive interaction between FDI and human capital that suggest that the benefits of FDI are conditional on the absorption capacity of recipients. Also a strong and robust net crowding out effect of FDI is shown. FDI and domestic investment do not demonstrate a significant interactive effect on economic growth. Lower levels of human capital coupled with net crowding out of the domestic investment serves to compromise the effects of FDI on growth for the region. Furthermore, physical capital is found to be a significant determinant of FDI inflows and economic growth. Malthusian theory that over population dissuades economic growth in the region is supported. The FDI-Uncertainty relationship varies across the alternative measures used for uncertainty. The standard deviation of the real effective exchange rate is inversely related to FDI. In contrast, uncertainty measures generated through GARCH drives FDI inflows to the region indicating different response to Risk vs. Uncertainty. Regime durability is found paying a positive premium to growth. This study contributes to the literature in two ways. First, it is the first study that we are aware of that analyzes the FDI-Uncertainty-Growth linkages for developing Asia. Secondly, the analyses are conducted using simultaneous framework that captures feedback between FDI, domestic investment and economic growth. This work also controls for simultaneity and endogeniety bias by employing Instrumental Variable (IV) estimation technique in SEM framework. Also our work contributes to empirical literature on uncertainty and FDI and uncertainty and economic growth by employing alternative measures of uncertainty which help better understand the nexus in context of risk vs. uncertainty hypothesis. Additionally, this work provides plausible reasons behind mixed results in previous work that has looked at FDI-growth linkages. Based on the findings, on the whole, we recommend formulating policies to produce efficient human capital through scientific education and creating market driven skills. Well devised population policy not only hinging on slowing down the population growth rates but also a better management of human capital should be devised. Most importantly, FDI inflows should be directed to selective sectors and areas where it can make complementarities with domestic capital. Physical infrastructure should be improved both in quality and quantity.